High risk of significant correction

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Livewire Markets

There have been some well publicised concerns raised recently about the prospect of elevated risks across asset markets. So, Livewire went on the hunt for insights on how to remain invested in the current market, firstly asking a selection of fund managers: From your perspective is there a heightened level of risk to current valuations? Our respondents told us that current valuations across most assets point to a high risk of a significant correction, that the bond-proxy stocks look very vulnerable, and that the high PE across industrial stocks are a concern. Read below for individual responses from Nikko AM, Schroders and Monash Investors.  

Risk of a significant correction is high

Simon Doyle, Head of Fixed Income & Multi-Asset, Schroders 

Current valuations across most assets tell us that future returns will be low and the risk of a significant correction is high. None of this means markets will collapse tomorrow, but it does mean that there is limited cushioning to absorb a shock. 

Putting aside the risks to individual asset classes, the bigger risk to investors is “shortfall risk”. In other words, stretched valuations and subsequent low prospective returns means that the typical “diversified” or balanced portfolio that relies largely on a relatively large and static allocation to equities will likely deliver returns to investors that are well short of their target. 

A potentially bigger risk is that low prospective returns encourage investors to do things to try and lift returns that ultimately backfire. This is not unusual late in the cycle. It happened prior to the GFC, it happened prior to the tech bubble, and it’s happening now. But, trying to boost returns through the injudicious use of leverage, or moving into illiquid assets, could prove costly.  There is after-all no free lunch.  

Bond-proxy stocks vulnerable for second sharp correction

Jason Kim, Senior Portfolio Manager, Nikko AM 

We believe there is a heightened level of risk to current valuations only in certain pockets of the market.  In our view, the bond-proxy (REITS, Utilities, Infrastructure) part of the market looks very vulnerable for a sharp correction again.  

They have now mostly recovered from the correction they suffered late last year after they hit extraordinary bubble like price levels when bond yields bounced off their lows.  This has come about as the market has more recently become concerned about economic growth in Australia again, and 10-year bond yields have recently dipped down after having only bounced off their lows last year. With that, the market has been buying these bond-proxy stocks again, to what we believe are very expensive levels yet again. 

We believe that the 10-year bond yield in Australia at 2.4% is still way below mid-cycle, and that we are likely be on track towards mid-cycle bond yields of around 4%-5% over the next few years, as the economy recovers over time.  As such, the bond-proxy part of the share market look set for another sharp correction as bond yields head higher. 

Valuation of industrial stocks leaves them vulnerable in particular

Simon Shields, Portfolio Manager, Monash Investors Limited  

Inflation and interest rates are very low by historical standards, so we would expect that price multiples would be fairly high. However, with pessimism about the growth outlook, and capital requirements of the banks weighing on the market, the weighted average market PE is sitting at around only 16x for 2017. 

Excluding the banks and resources, industrial stocks are closer to 20x, which is getting up there. The higher price multiples for those industrial stocks leaves them more susceptible to sharp price drops if their expected growth disappoints. 

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